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If the practice or related entity owns the office building, a commercial real-estate appraiser
normally appraises the structure. If the office is leased, the leasehold may have a value
depending upon the number of years remaining, amount paid for rent compared to going
market rent, and the ability to renew the lease, DeMuth explains.
Office location and profitability are also important, according to Kropiewnicki. If a practice
is in the middle of nowhere, rural versus suburban Pennsylvania or New Jersey, then the rural
practice will almost certainly be worth less than the suburban practice, all else being equal,
he says. Also, profitability is a major factor, so if you have two practices in the same
geographic area each grossing $1 million, and one physician is making $300,000 and the
other physician is netting out $500,000, a buyer should be willing to pay more for the more
profitable practice.
While there are numerous factors which could affect it, the value of goodwill is generally
dependent upon the ability of the purchaser to be able to earn a superior return from the
practice compared with what could normally be expected to be earned by physicians in the
specialties represented in the practice, DeMuth says.
The Health Care Group publishes the Goodwill Registry, a large database of healthcare
practice transactions from all over the country and source of actual goodwill values paid. It
lists goodwill as a percentage of a practices gross income and has other financial information
about the practices reported to them by specialty.
When buying a home, comparables existyou can compare homes in different
neighborhoods, Kropiewnicki says. No neighborhood level comparables exist like that
when it comes to medical practices. The Goodwill Registry comes closest to providing
healthcare practice comparables, but on a wider geographic scale.
Although its usually inappropriate to solely apply rules-of-thumb in valuing medical
practices, especially goodwill and intangible assets, the Goodwill Registry can be used to
support or confirm the valuation results achieved using other valuation methods.
Even when using a database of sales data, significant thought needs to go into understanding
similarities and differences in published data, such as the Goodwill Registry. Some data is
based on matrimonial disputes, some are arms-length sales, some are based on internal sales
transactions which may have other, tax driven components to them. Failure to fully take these
issues into account is likely to lead to erroneous conclusions, Glusman says.
Goodwill:
Definition and Valuation of Goodwill
Definition:
A business builds up some reputation after it has continued for some time. If
the reputation is good, the firm will come to acquire a fixed clientele in the sense that a
number of customers will automatically make their purchases from the firm. This is a very
valuable asset even if one cannot touch or see it. The asset is intangible but not fictitious. This
asset is known as goodwill and may be defined as the value of the reputation of a firm. Its
tangible effect is extra profit which firms not possessing equal reputation do not earn.
Valuation of Goodwill:
If, goodwill is to be valued at 3 years purchase of average profits for. 5 years, goodwill will
be Rs 85,000 x 3 = Rs 2, 55,000.
Then, from this figure, the net assets (excluding goodwill) of the firm are deducted and the
remainder is goodwill. In the example given above, the value of the whole business is
The necessity for the valuation of goodwill in a firm arises in the following cases:
(a) When the profit-sharing ratio amongst the partners is changed;
(b) When a new partner is admitted;
(c) When a partner retires or dies; and
(d) When the business is sold;
In the last case, obviously, the value of goodwill will be a matter for negotiation between the
firm and the intending purchaser.
Accounting Treatment of Goodwill :
Because of the provisions of the Accounting Standard 10 on Accounting for Fixed Assets,
accounting treatment of goodwill has undergone a fundamental change.
Consider extract of the Accounting Standard which runs as follows :
Goodwill should be recorded in the books only when some consideration in money or
moneys worth has been paid for it. Whenever a business is acquired for a price (payable in
cash or in shares or otherwise) which is in excess of the value of net assets of the business
taken over, the excess should be termed as goodwill.
It means that goodwill can appear in the books only when it has been paid for. When a
business is acquired and the consideration paid for it exceeds the fair amount paid for net
assets other than goodwill, such excess can be recorded as goodwill.
Suppose, P and Q are equal partners in a firm. They take over the business of XY (Pvt.) Ltd.
for Rs 20, 00,000 payable in cash.
On the date of the takeover, the abridged balance sheet of the private company is as
follows:
The firm takes over all the assets and liabilities at book values except that machinery is
valued by an expert at Rs 8, 94,000 and a provision for bad debts @2% is created against
debtors.
The journal entries in the books of the partnership firm will be as follows:
A firm cannot raise a goodwill account for internally generated goodwill although it may be
sure that if it sells its business, it will be able to get a certain sum of money for its goodwill.
A, B and C are partners who were sharing profits in the ratio of 6:5:2 respectively. On 1st
April, 2010, they, agree to become equal partners. The value of firms goodwill is agreed
upon to be Rs 78,000. Pass the necessary adjustment entry.
Profit/Loss ($)
2005
10,000,000
2006
12,250,000
2007
7,450,000
2008
2,450,000 (Loss)
2009
12,400,000
For example, the capital employed as shown by the books of ABC Ltd is $
50,000,000. And the normal rate of return is 10 %. Goodwill is to be calculated on the basis
of 3 years puchase of super profits of the last four years. Profits for the last four years are:
Year
Profit/Loss ($)
2005
10,000,000
2006
12,250,000
2007
7,450,000
2008
5,400,000
Total profits for the last four years = 10,000,000 + 12,250,000 + 7,450,000 + 5,400,000 =
$35,100,000
Average Profits = 35,100,000 / 4 = $ 8,775,000
Normal Profits = 50,000,000 X 10/100 = $ 5,000,000
Super Profits = Average/ Actual Profits Normal Profits = 8,775,000 5,000,000 = $
3,775,000
Goodwill = 3,775,000 3 = $ 11,325,000
3. Capitalisation Method:
There are two ways of calculating Goodwill under this method:
(i) Capitalisation of Average Profits Method
(ii) Capitalisation of Super Profits Method
(i) Capitalisation of Average Profits Method :
Under this method we calculate the average profits and then assess the
capital needed for earning such average profits on the basis of normal rate of return. Such
capital is called capitalised value of average profits. The formula is:Capitalised Value of Average Profits = Average Profits X (100 / Normal Rate of Return)
(ii) Calculate future-maintainable profit before tax after making past adjustments.
(iii) Calculate Average Past adjusted Profits (taking simple average or weighted average as
applicable).
(iv) Multiply Future Maintainable Profits by number of years purchase.
Value of Goodwill = Future Maintainable Profits x No. of years purchase.
Illustration 1:
X Ltd. agreed to purchase business of a sole trader. For that purpose, goodwill is to be valued
at 3 years purchase of average profits of last 5 years.
Illustration 2:
Y Ltd. proposed to purchase business carried on by Mr. A. Goodwill for this purpose is
agreed to be valued at 3 years purchase of the weighted average profits of the past four
years.
The profit for these years and respective weights to be assigned are as follows:
Solution:
Before calculating goodwill, it is necessary to compute adjusted profit on the basis of
information given.
2.
Super Profit Method:
Super profit is the excess of estimated future maintainable profits over normal profits. An
enterprise may possess some advantages which enable it to earn extra profits over and above
the normal profit that would be earned if the capital of the business was invested in some
other business with similar risks. The goodwill under this method is ascertained by
multiplying the super profits by certain number of years purchase.
3. Capitalization Method:
Goodwill under this method can be calculated by capitalizing average normal profit or
capitalizing super profits.
(i) Capitalisation of Average Profit Method:
Under this method goodwill is ascertained by deducting Actual Capital
Employed (i.e., Net Assets as on the valuation date) from the capitalised value of the average
profits on the basis of normal rate of Return (also known as value of the firm or capitalised
value of business)
Illustration 6:
Balance Sheet of X Ltd. on 31st March, 2013 was as under:
4. Annuity Method :
Under this method, goodwill is calculated by taking average super profit as the value of an
annuity over a certain number of years. The present value of this annuity is computed by
discounting at the given rate of interest (normal rate of return). This discounted present value
of the annuity is the value of goodwill. The value of annuity for Rupee 1 can be known by
reference to the annuity tables.
If the value of annuity is not given, it can be calculated with the help of following
formula:
Illustration 7:
The net profit of a company after providing for taxation for the past five years
is:
The net tangible assets in the business are Rs. 4, 00,000 on which the normal rate of
return is expected to be 10%. It is also expected that the company will be able to
maintain its super profits for next five years. Calculate the value of goodwill of the
business on the basis of an annuity of super profits, taking present value of an
annuity of Rs. 1 for five years at 10% interest is Rs. 3.78.
Defination of Shares :
A unit of ownership that represents an equal proportion of a company's capital.
It entitles its holder (the shareholder) to an equal claim on the company's profits and an
equal obligation for the company's debts and losses.
Two major types of shares are :
(1) ordinary shares (common stock), which entitle the shareholder to share in the earnings of
the company as and when they occur, and to vote at the company's annual general
meetings and other official meetings, and
(2) preference shares (preferred stock) which entitle the shareholder to a fixed
periodic income (interest) but generally do not give him or her voting rights. See also stock.
(f) The balance left is called the Net Assets or Funds Available for Equity
Shareholders.
The following chart will make the above principle clear:
Alternatively:
Net Assets = Share Capital + Reserves and Surplus Revaluation Loss on
Revaluation
Applicability of the Method:
(i) The permanent investors determine the value of shares under this method at the
time of purchasing the shares;
(ii) The method is particularly applicable when the shares are valued at the time of
Amalgamation, Absorption and Liquidation of companies; and
(iii) This method is also applicable when shares are acquired for control motives.
Illustration 1:
From the following Balance Sheet of Sweetex Ltd. you are asked to-ascertain the
value of each Equity Share of the company:
For the purpose of valuing the shares of the company, the assets were revalued as:
Goodwill Rs. 50,000; Land and Building at cost plus 50%, Plant and Machinery Rs.
1, 00,000; Investments at book values; Stock Rs. 80,000 and Debtors at book value,
less 10%.
Intrinsic Value of each share = Funds available for Equity Shares/Total Number of
Shares
Intrinsic Value of shares = Rs. 3, 30,000/20,000
= Rs. 16.50.
Intrinsic Value of Shares on the Basis of Valuation of Goodwill
Illustration 2:
X Ltd. presented the following Balance Sheet as on 31st March 2010:
Additional Information:
(a) Land and Building and Plant and Machinery were revalued at Rs. 15, 00,000 and
Rs. 2, 28,000, respectively.
(b) Investments were valued at market value.
(c) Stock to be taken at Rs. 80,000 and Debtors subject to a deduction @ 10% for
bad debts.
(d) Net profit (before Tax) for the last five years were: Rs. 50,000; Rs. 70,000; Rs.
80,000; Rs. 1, 00,000 and Rs. 1, 25,000.
(e) Managerial Remuneration Rs. 8,000 to be charged against profit for every year.
(f) Normal Rates of Return 10%.
(g) Goodwill to be valued at 5 years purchase of Super-Profit.
(h) Rate of tax 50%.
Ascertain the Intrinsic Value of Shares.
The following Balance Sheets were presented by X Ltd. and Y Ltd. as on 31st
Dec. 2008:
Solution:
(a) Calculation of Intrinsic Value of Shares:
Thus, the ratio of exchange is 5,000 shares of X Ltd. for 10,000 shares of Y Ltd. i.e.,
the ratio is 1 : 2 or 1 share of X Ltd. is equal to 2 shares of Y Ltd.
B. Yield-Basis Method:
Yield is the effective rate of return on investments which is
invested by the investors. It is always expressed in terms of percentage. Since the
valuation of shares is made on the basis of Yield, it is called Yield-Basis Method. For
example, an investor purchases one share of Rs. 100 (face value and paid-up value)
at Rs. 150 from a Stock Exchange on which he receives a return (dividend) @ 20%.
(dividend) @ 20%.
Profit Basis:
Under this method, at first, profit should be ascertained on the basis of past
average profit; thereafter, capitalized value of profit is to be determined on the
basis of normal rate of return, and, the same (capitalized value of profit) is divided
by the number of shares in order to find out the value of each share.
Illustration 4:
Two companies, A Ltd. and B. Ltd., are found to be exactly similar as to their
assets, reserves and liabilities except that their share capital structures are
different:
The share capital of A. Ltd. is Rs. 11,00,000, divided into 1,000, 6% Preference
Shares of Rs. 100 each and 1,00,000 Equity Shares of Rs. 10 each.
The share capital of B. Ltd. is also Rs. 11,00,000, divided into 1,000, 6% Preference
Shares of Rs. 100 each and 1,00,000 Equity Shares of Rs. 10 each. .
The fair yield in respect of the Equity Shares of this type of companies is ascertained
at 8%.
The profits of the two companies for 2009 are found to be Rs. 1, 10,000 and Rs. 1,
50,000, respectively.
Calculate the value of the Equity Shares of each of these two companies on
31.12.2009 on the basis of this information only. Ignore taxation.
Illustration 5:
From the following information of J. Adams Co. Ltd. compute the value of its
equity share by capitalisation of earning method:
It is the usual practice of the company to transfer Rs. 30,000 every year to General
Reserve. Assume rate of Taxation is at 50% and the rate of normal earnings at
12.5%.
Whether Profit Basis or Dividend Basis method is followed for ascertaining the value
of shares depends on the shares that are held by the respective shareholders. In
other words, the shareholders holding minimum number of shares (i.e., minority
holding) may determine the value of his shares on dividend basis since he has to
satisfy himself having the rate of dividend which is recommended by the Board of
Directors, i.e., he has no such power to control the affairs of the company.
On the contrary, the shareholders holding maximum number of shares (i.e., majority
holding) has got more controlling rights over the affairs of the company including the
recommendation for the rate of divided among others. Under the circumstances,
valuation of shares should be made on profit basis. In short, Profit Basis should be
followed in the case of Majority Holding, and Dividend Basis should be followed in
the case of Minority Holding.
The same principle may be represented in the following form:
Note:
Yield-Basis Method may also be termed as:
Market Value Method; Profit Basis/Income Basis Method;
Earning Capacity Method etc.
Value of share under yield basis:
Illustration 6:
On December 31, 2009 the Balance Sheet of MA KALI Ltd. disclosed the following
position:
Illustration 7:
Calculate the value of each Equity Share from the following information:
Illustration 8:
The following is the Balance Sheet of X Co. Ltd. as on 31.12.2009:
Ascertain the value of each equity share under Fair Value Method on the basis
of the information given:
E.
Illustration 10:
Compute the value per share and valuation of the business from the following
particulars:
Conclusion :
Bibliography / References :
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